Trading the market or trading the volatility?
This has so far, been an unusual week in the markets.
Typically, the first 2 weeks of the year are poor to trade. Volumes are normally to the low side and it can be fairly tight.
What we actually saw was the opposite. Volume and Volatility have been high.
Here was my prep for Monday – low expectations: https://www.topsteptrader.com/s-p-futures-daily-pre-market-prep-and-levels-1-5
Here was my prep for Tuesday (yesterday): https://www.topsteptrader.com/s-p-futures-daily-pre-market-prep-and-levels-1-6
What we got yesterday on the eMini S&P500 (ES) was this (click to enlarge):
Overnight, we got stuck in the range we’d marked out the prior afternoon. The same thing happened for the first hour of the day until we finally broke down. Nothing unusual about that.
What IS unusual is the size of the swings. Moving 20-40 ticks in one fluid movement with little pullback in the ES is unusual. If you look at Monday, the swing sizes there are extreme too. This is similar to the activity we had in December.
Which brings us to the point. Whether you are trading Gold, Crude, Forex, Indices or Treasuries, what is it you are actually trading?
- You are trading the characteristics of that market
- You are trading against the other participants in that market
- You are trading against other short term speculators in that market
- You are sometimes piggybacking large moves because of major re-positioning
- You are relying somewhat on Market Makers in that market to behave in a certain way
So what do you do when the characteristics of that market changes from ‘the norm’ as we saw in late December and now in early January? When the amount of participation (volume) changes? When Market Makers run for the hills because it’s a bit too risky for them?
You can do one of two things. You can adjust OR you can switch to a market that has the behavior you are used to trading.
Crude traders are people that like fast paced markets. When Crude slows down, those traders may struggle, they are no longer in their comfort zone. Moving to a market that has the pace and participation they are used to makes more sense than trying to become a different type of trader.
For those trading the ES, this additional volatility means that you have less time to make a decision, you will be stopped out more and you will be putting orders in and seeing the market move away from them (in your direction) without getting a fill. That of course, presuming that you aren’t making serious adjustments for the volatility.
For ES Traders looking for the sort of conditions they are used to trading we have a few options. We can look at the EuroStoxx 50 (FESX). That tends to be thicker than the ES but right now, that looks volatile too. US Treasuries tend to be much slower than the ES. If we take a look at the US Treasury Bonds (ZB) and the 10 Year Notes (ZN) they are also more volatile than normal. The action there, in terms of swing sizes and volume looks more the sort of market conditions an ES Trader would be used to.
10 Year Notes
US Treasury Bonds
For ES Traders, you may find that these markets are more like the ES than the ES is right now.
What about beginners?
For the order flow veterans, you can see that these conditions present a challenge. The price action and the order flow are not what you are used to. You are missing out on trades because the market is so much faster than you are used to. Even chasing a trade when you miss a fill is problematic because it’s moving 4-5 ticks off an inflection point very quickly. For the veterans, it’s easy to stand to one side or just get in with a larger stop and track the flow after your entry to manage to the trade. The veterans advantage is that they know it’s different right from the start of the day. It’s fairly clear and so getting caught out by it is unlikely.
For those new to Order Flow and with a long term focus of trading a thicker market like the ES, it makes a lot more sense look at a slower market, especially if you are just going through the learning process. The ZN and ZB currently look like the best 2 markets to do that.
Will it be this way forever?
The markets tend to shift up and down gears regularly. In 3 months time you may well be reading a post about how the markets are crawling very slowly and which markets are in the ‘sweet spot’ right now.
Recognizing and adjusting to volatility changes are skills you will develop over time. It’s always good to have an overview of the markets though as changes in one area tend to have a ripple effect to other markets. If you find yourself looking around for a different market to look at when volatility changes, this page on the CME Website is a good place to start.
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Order Flow itself is simply information. Just like charts, it can be used in a number of ways, some good and some bad. But let's first break down order flow into it's components so we all agree what we are talking about:
Order Executions/Tape Reading - This aspect is the real flow of orders. It's the information we see in Time & Sales, Footprint Charts, Cumulative Delta. It is looking at market orders, either as they execute or historically. I guess this is the "true order flow". Every trade is a buy and a sell. We look at market orders because we consider them to be more aggressive. When someone trades with a market orders, they are giving up a price to get an instant fill. Limit orders on the other hand just lazily sit there waiting for a market order to hit them. Often these are market makers with no directional conviction. So we see market orders as being more significant.
But we don't use these in isolation.
Volume Profile/Positions - The tape reading part helps us assess various things like momentum, traders getting stuck, balance of trade BUT the volume profile helps us understand where people are positioned and likely to get stopped out. I sometimes call this "Order Flew". It's important to know when trades will be "washed out" - for example - if we have a volume cluster on the S&P500 Futures and the market moves up 100 points and back down to it, it's unlikely short term traders on either side that were positioned there will still be there. But recent, nearby volume helps us assess areas of positions.
Market Depth - The bids and offers, the lazy passive orders waiting to be hit. This is part of the story but in terms of overall importance, I'd put it at around 20% at most. For example - if you return to the high of the day on any market, the offers will be quite large directly above the high. It means nothing at all. It's just a quirk of the market. It does not help you tell if a price will hold. On the other hand, if you see large depth and as we approach it, we see more added to the depth in front of that price, it means others are front running that depth and that is a useful bit of information.
This is the key - it is all just information. Just like price charts are information. When people look at Order Flow, they consider it to be a technique more than a set of information. They look for things like iceberg orders and decide to make a one rule trading system to fade every iceberg, For these people - yes, order flow trading is overrated because they are trying to ignore everything else going on in the markets and construct a trading system a chimp could execute.
For those looking to improve a decent trading approach, the best thing to focus on in Order Flow is momentum. Once you can read momentum you can:
- Avoid getting into positions when momentum is against you.
- Confirm trades are working after entry when momentum goes your way.
- Exit trades in profit when momentum fades.
That's perhaps the easiest way to use order flow because momentum is easier to read. It's about the market continuing to do what it's already doing. On the other hand, reading a turn in the market with order flow takes a higher level of skill and a little longer to learn.
Order flow can't put lipstick on a pig. It won't help you 'improve' something that doesn't work anyway, which is why whenever someone calls me, the first thing I ask is what they are currently doing and we discuss whether they need a reset or whether it will actually help.
When Jigsaw started back in 2011 - we were one of the first in the space and certainly had the best education. It was always going to attract the underbelly of the trading education/tools world and now we see stuff out there that is so complex but so impressive and futuristic that new traders are drawn to it like moths to a flame.
So here's my advice when looking at Order Flow
- Order Flow can't improve something that doesn't work.
- Order Flow can be used on it's own, without charts to enter and exit the market but you also have to be able to recognize different market states that need different/altered setups. There is nothing magical about this.
- Don't start jumping at shadows and take 50 trades an hour in your first week looking at Order Flow, be selective. It can be exciting to see cause and effect play out in front of you for the first time but don't overtrade.
- Do drills to learn how to read it before you trade it.
- Markets can only go up and down. Don't overcomplicate it. If you have too many Order Flow tools on your screen - you will not be able to make consistent decisions. Less is more.
- Take time to choose a market with a pace you like. Interest rates might send you to sleep, the DAX might give you a heart attack.
It is hard to see how a set of information could be overrated. It is true that some methods of presenting this information are better than others. It is also true that some people simply get on better with different tools (e.g. Footprint vs DOM).
There's a middle ground between complexity and simplicity that will leave you making consistent decisions where you improve over time. For those people, Order Flow will be way underrated because they will be the one's getting the most out of it.
Those that jump in with both feet on day one and those that have 100 different tools up, for those, it's a painful experience.
Keep it simple and manageable. Start with momentum reading and build from there. You will never look back.
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